The issue of whether the acquisition of a new asset can be structured as a lease with a later purchase option has always been a thorny one in our tax system. And now, with ag lenders increasingly chasing fewer quality transactions, we see these deals becoming more aggressive, especially those related to newly constructed buildings.

THE MOTIVATION

The economics of tax deductions clearly favor a lease, particularly with respect to longer-term depreciable property such as buildings. A new machine shed must be depreciated over 20 years. But if you lease the structure, say for seven years, and then exercise a buyout option at the end of the lease, much of the value will be deducted as rental payments over the initial seven years. Only the residual purchase option in year eight becomes depreciable, and that is a much-reduced amount.

THE IRS FOCUS

The IRS is well aware of attempts to disguise financed purchases as lease arrangements. Here is an abbreviated example from their Publication 225, Farmer's Tax Guide: "You lease new farm equipment from a dealer. The agreement includes an option to purchase the equipment for a specified price. The lease payments and the specified option price equal the sales price of the equipment plus interest. Under the agreement, you are responsible for maintenance, repairs and the risk of loss. For federal income tax purposes, the agreement is a conditional sales contract. You cannot deduct any of the lease payments as rent, and we will throw you in jail if you do this."

I made up the last part about jail, but you get the point. If an IRS exam converts immediate lease deductions into deferred depreciation deductions, with the usual interest and possible penalties, it's not a pleasant outcome.

THE CRITERIA

There is no bright-line test to determine whether an arrangement is a true lease or a financed sale arrangement. The IRS identifies several factors, however, to help make the call:

-- The overall lease payments approximate the purchase price plus interest.

-- The agreement applies part of each payment toward an equity interest in the property.

-- The annual payment is much more than the current fair rental value to lease the property for a year.

-- The option to buy the property at the end of the lease is nominal compared to today's expectation of the value of the property at the option exercise point.

With respect to leased building acquisitions, there is the further economic issue of the severability of the lessor's asset. Is it economically realistic to expect that non-payment of the lease would result in the lessor removing that building?

SUMMARY

Leases can certainly be a valid form of acquiring the use of property, while deferring the actual acquisition to a later point under an option clause. But be careful of over-zealous lenders who represent traditional financing arrangements as leases. It takes more than a heading at the top of the document to make it a lease in the eyes of the IRS.

Editor's Note: DTN Tax Columnist Andy Biebl is a CPA and principal with the accounting firm of LarsonAllen in New Ulm, Minn., and a national authority on ag taxation. Pose your tax questions by e-mailing AskAndy@dtn.com. For more insights into how to optimize today's lower tax climate, listen to Biebl's pre-recorded, 60-minute 2009 tax strategy webinar at http://about.dtnpf.com/…

(MZT/AG)

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